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INVESTMENT
VAULT CAREER GUIDE TO
2008 EDITION
is made possi...
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The media’s watching Vault!
Here’s a sampling of our covera...
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Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
© 2007 Vault Inc.
INVEST
BANKIN
CAREE
VAULT CAREER GUIDE TO...
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Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
TOM LOTT, DEREK LOOSVELT, WILLIAM JARVIS
AND THE STAFF OF V...
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Copyright © 2007 by Vault Inc. All rights reserved.
All inf...
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ACKNOWLEDGMENTS
We are extremely grateful to Vault’s entire...
Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
Visit the Vault Finance Career Channel at www.vault.com/fin...
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Vault Career Guide to Investment Banking
Table of Contents
...
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Vault Career Guide to Investment Banking
Table of Contents
...
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G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e...
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INVEST
BANKIN
CAREE
THE INDUSTRY
Chapter 1: What is Investm...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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stop shopping” for M&A advice, bond offerings, etc. for cli...
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there will usually be a page with tombstones (icons of prev...
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© 2007 Vault Inc.6
Vault Career Guide to Investment Banking...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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Vault Career Guide to Investment Banking
What is Investment...
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Vault Career Guide to Investment Banking
What is Investment...
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Vault Career Guide to Investment Banking
What is Investment...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.1212
Commercial banks
A commercial bank ma...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.1414
Vault Career Guide to Investment Bank...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.1616
Ultimately, when choosing to raise ca...
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Glass-Steagall’s fall in the late 1990s
In the late 1990s, ...
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What took so long?
So why did it take so long to enact a re...
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Vault Career Guide to Investment Banking
Commercial Banking...
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© 2007 Vault Inc.20
Conversely, as the nature of the busine...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.2222
In November 1999, the Dow Jones updat...
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positive global economic data, and the rise of corporate pr...
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© 2007 Vault Inc.2424
financial markets worldwide. Many inv...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.2626
What moves individual stocks?
When it...
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PEG ratio
Because companies grow at different rates, anothe...
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taxes are paid only if a company is profitable after it has...
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Vault Career Guide to Investment Banking
The Equity Markets...
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Vault Career Guide to Investment Banking
The Equity Markets...
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How many consulting
job boards have you
visited lately?
(Th...
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Visit the Vault Finance Career Channel at www.vault.com/fin...
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© 2007 Vault Inc.3434
Beginning in the early 1980s, however...
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© 2007 Vault Inc.3636
example, if the Acme Corp. 10-year bo...
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© 2007 Vault Inc.3838
Why do interest rates move?
Interest ...
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  1. 1. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary INVESTMENT VAULT CAREER GUIDE TO 2008 EDITION is made possible through the generous support of the following sponsors: BANKING
  2. 2. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary The media’s watching Vault! Here’s a sampling of our coverage. “For those hoping to climb the ladder of success, [Vault’s] insights are priceless.” – Money magazine “The best place on the web to prepare for a job search.” – Fortune “[Vault guides] make for excellent starting points for job hunters and should be purchased by academic libraries for their career sections [and] university career centers.” – Library Journal “The granddaddy of worker sites.” – U.S. News & World Report “A killer app.” – New York Times One of Forbes’ 33 “Favorite Sites” – Forbes “To get the unvarnished scoop, check out Vault.” – SmartMoney Magazine “Vault has a wealth of information about major employers and job- searching strategies as well as comments from workers about their experiences at specific companies.” – The Washington Post “A key reference for those who want to know what it takes to get hired by a law firm and what to expect once they get there.” – New York Law Journal “Vault [provides] the skinny on working conditions at all kinds of companies from current and former employees.” – USA Today
  3. 3. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  4. 4. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc. INVEST BANKIN CAREE VAULT CAREER GUIDE TO INVESTMENT BANKING
  5. 5. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  6. 6. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary TOM LOTT, DEREK LOOSVELT, WILLIAM JARVIS AND THE STAFF OF VAULT © 2007 Vault Inc. INVEST BANKIN CAREE VAULT CAREER GUIDE TO INVESTMENT BANKING
  7. 7. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Copyright © 2007 by Vault Inc. All rights reserved. All information in this book is subject to change without notice. Vault makes no claims as to the accuracy and reliability of the information contained within and disclaims all warranties. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express written permission of Vault Inc. Vault, the Vault logo, and “The Most Trusted Name in Career InformationTM ” are trademarks of Vault Inc. For information about permission to reproduce selections from this book, contact Vault Inc., 150 West 22nd Street, New York, NY 10011, (212) 366-4212. Library of Congress CIP Data is available. ISBN 10 : 1-58131-532-5 ISBN 13 : 978-1-58131-532-5 Printed in the United States of America
  8. 8. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary ACKNOWLEDGMENTS We are extremely grateful to Vault’s entire staff for all their help in the editorial, production and marketing processes. Vault also would like to acknowledge the support of our investors, clients, employees, family, and friends. Thank you!
  9. 9. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  10. 10. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. ixC A R E E R L I B R A R Y THE INDUSTRY Chapter 1: What is Investment Banking? 3 The Players . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 The Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Chapter 2: Commercial Banking, Investment Banking and Asset Management 11 Commercial Banking vs. Investment Banking . . . . . . . . . . . . . . . . . . . . . .11 Glass-Steagall Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 The Buy-Side vs. the Sell-Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Chapter 3: The Equity Markets 21 Bears vs. Bulls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Stock Valuation Measures and Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Value Stocks, Growth Stocks and Momentum Stocks . . . . . . . . . . . . . . . .30 Chapter 4: The Debt Markets 33 What is the Bond Market? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33 Bond Market Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Fixed Income Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41 What is the Loan Market? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43 Chapter 5: Trends in I-Banking 47 A Record Year for M&A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 Graduates: Too Hot To Handle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52 Chapter 6: Equity and Debt Offerings 53 Initial Public Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53 Follow-On Offerings of Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 Bond Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57 Loan Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59 Table of Contents
  11. 11. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  12. 12. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking Table of Contents Visit the Vault Finance Career Channel at www.vault.com/finance — with insider firm profiles, message boards, the Vault Finance Job Board and more. xiC A R E E R L I B R A R Y Chapter 7: M&A, Private Placements, and Reorgs 61 Mergers & Acquisistions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Private Placements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65 Financial Restructurings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66 ON THE JOB Chapter 8: Corporate Finance 73 The Players . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74 The Role of the Players . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .77 The Typical Week in Corporate Finance . . . . . . . . . . . . . . . . . . . . . . . . . . .87 Formulas for Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .98 Chapter 9: Institutional Sales and Trading 103 Trading – The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106 Executing a Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112 Trading – The Players . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119 Trading – The Routine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123 Institutional Sales – The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128 Institutional Sales – The Players . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129 Private Client Services (PCS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .135 Chapter 10: Research 139 The Players and the Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139 Three Months in Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147 Formulas for Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152
  13. 13. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  14. 14. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking Table of Contents Visit the Vault Finance Career Channel at www.vault.com/finance — with insider firm profiles, message boards, the Vault Finance Job Board and more. xiiiC A R E E R L I B R A R Y Chapter 11: Syndicate: The Go-Betweens 155 APPENDIX Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165 Recommended Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179
  15. 15. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b | C i t i g r o u p L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o | D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s | P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b | C i t i g r o u p | L e h m a n B r o t h e r s A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o | D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n J P M o r g a n C h a s e | H S B C | M o o d y ' s | P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b | C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o | D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e H S B C | M o o d y ' s | P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S C h a r l e s S c h w a b | C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o | D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | C h a r l e s S c h w a b C i t i g r o u p | L e h m a n B r o t h e r s | A m e r i c a n E x p r e s s | S a l l i e M a e | W e l l s F a r g o D e u t s c h e B a n k | P u t n a m I n v e s t m e n t s | S t a n d a r d & P o o r ' s | K P M G | E r n s t & Y o u n g | L e g g M a s o n | J P M o r g a n C h a s e | H S B C | M o o d y ' s P r i c e w a t e r h o u s C o o p e r s | E d w a r d J o n e s | L a z a r d | B a n k o f A m e r i c a | C r e d i t S u i s s e F i r s t B o s t o n | G o l d m a n S a c h s | M e r r i l l L y n c h | F i d e l i t y | D e l o i t t e | B e a r S t e a r n s | T h e B l a c k s t o n e G r o u p | M o r g a n S t a n l e y | U B S | GO FOR THE GOLD! GET VAULT GOLD MEMBERSHIP AND GET ACCESS TO ALL OF VAULT'S AWARD-WINNING FINANCE CAREER INFORMATION Employee surveys on 100s of top finance employers with insider info on: • Company culture • Salaries and compensation • Hiring process and interviews • Business outlook Access to 100+ extended insider finance employer profiles Complete access to Vault's exclusive finance firm rankings, including quality of life rankings Insider salary info with Vault's Finance Salary Central Student and alumni surveys for 100s of top MBA programs and law schools Receive Vault's Finance Job Alerts of top jobs posted on the Vault Finance Job Board Access to complete Vault message board archives 15% off all Vault purchases, including Vault Guide and Finance Employer Profiles, Vault's Finance Interview Prep and Vault Resume Reviews (the WSJ’s “top choice”)
  16. 16. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary INVEST BANKIN CAREE THE INDUSTRY Chapter 1: What is Investment Banking? Chapter 2: Commercial Banking, Investment Banking and Asset Management Chapter 3: The Equity Markets Chapter 4: The Debt Markets Chapter 5: Trends in the Investment Banking Industry Chapter 6: Stock and Bond Offerings Chapter 7: Mergers and Aquisitions, Private Placements, and Reorganizations
  17. 17. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary
  18. 18. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 3C A R E E R L I B R A R Y What is investment banking? Is it investing? Is it banking? Really, it is neither. Investment banking, or I-banking, as it is often called, is the term used to describe the business of raising capital for companies and advising them on financing and merger alternatives. Capital essentially means money. Companies need cash in order to grow and expand their businesses; investment banks sell securities (debt and equity) to investors in order to raise this cash. These securities can come in the form of stocks, bonds, or loans, which we will discuss in depth later. Once issued, these securities trade in the global financial markets. The Players The biggest investment banks include Goldman Sachs, JPMorgan, Merrill Lynch, Morgan Stanley, Credit Suisse, Citigroup’s Global Corporate Investment Bank, and Lehman Brothers, among others. Of course, the complete list of I-banks is substantially more extensive, but the firms listed above compete for the biggest deals both in the U.S. and worldwide. They are usually referred to as “bulge bracket” investment banks. You have probably heard of many of these firms, and perhaps have a brokerage account with the commercial banking arm of one of them. While the brokerage presence of these firms covers every major city in the U.S., the headquarters of almost every one of these firms is in New York City, the epicenter of the I-banking universe. It is important to realize that investment banking and brokerage go hand-in-hand, but that brokers are one small cog in the investment banking wheel. As we will cover in detail later, brokers sell securities and manage the portfolios of “retail” (or individual) investors. This raises a very important distinction in the world of investment banking. A number of firms have remained “pure” investment banks (Goldman Sachs, Lehman Brothers, Morgan Stanley), while others have commercial banking arms (JPMorgan, Citigroup, Bank of America). Until recently, these two were completely separate entities; while the investment bank would provide M&A and other strategic financial advice to companies, the commercial bank would lend capital (often times the advice requires capital). However, as firms evolved, many found they could become “one What is Investment Banking? CHAPTER 1
  19. 19. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary stop shopping” for M&A advice, bond offerings, etc. for clients. These global financial institutions are able to tap the vast network of deep relationships they have with small clients and turn those into large transactions as the clients become larger. As you will see from the league tables (discussed later), many of these investment banks with commercial arms are the biggest dealmakers on Wall Street. Many an I-banking interviewee asks, “Which firm is the best?” The answer, like many things in life, is unclear. There are many ways to measure the quality of investment banks. You might examine a bank’s expertise in a certain segment of investment banking. For example, Citigroup was tops in 2006 in total debt and equity underwriting volume, but trailed Goldman Sachs in mergers and acquisitions (“M&A”) advisory. Goldman Sachs, as a pure investment bank, has a stellar reputation in equity underwriting and M&A advisory but is not nearly as strong in debt issuance. The debt markets belong to the larger investment banks with commercial banking arms, such as Citigroup and JPMorgan. With larger balance sheets (due to customer deposits, among a variety of other things), these banks are able to leverage their size to take on more underwriting risk (more on underwriting later). By underwriting more transactions and becoming a one-stop-shop, these firms now have a very substantial presence in M&A, IPO, and equity-related volume. They can focus on executing every possible deal in the market, whereas the pure investment banks might focus on a particular area (M&A at Goldman, for example). Those who watch the industry pay attention to “league tables,” which are rankings of investment banks in several categories (e.g., equity underwriting or M&A advisory). The most commonly referred to league tables are published quarterly by Thomson Financial Securities Data (TFSD), a research firm based in Newark, N.J. TFSD collects data on deals done in a given time period and determines which firm has done the most deals in a given sector over that time period. Essentially, the league tables are rankings of firm by quantity of deals in a given area. However, readers should be aware that the only truly unbiased source of information comes from these independent firms, such as Thomson, and not from the investment banks themselves. League tables are merely a compilation of the volume of transactions (either by deal size or by number of deals) and can be easily manipulated by the investment banks for bragging purposes. For example, in just about every pitch made to a client, Vault Career Guide to Investment Banking What is Investment Banking? © 2007 Vault Inc.44
  20. 20. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary there will usually be a page with tombstones (icons of previous deals done by an I-bank), along with league tables, showing the firm’s expertise in a given area. Many times, analysts and associates will find themselves creating favorable league tables at late hours of the night to show how their firm is truly the best in a particular market segment, for transactions of a certain size, and so forth. Vault also provides prestige rankings of the Top 50 banking firms, based on surveys of finance professionals. These rankings are available on our web site, www.vault.com. Of course, industry rankings and prestige ratings don’t tell a firm’s whole story. Since the pay scale in the industry tends to be comparable among different firms, potential investment bankers would be wise to pay attention to the quality of life at the firms they’re considering for employment. This includes culture, social life and hours, which differs greatly even within different groups at the same firm. You can glean this information from your job interviews as well as reports on the firms available from Vault. Vault Career Guide to Investment Banking What is Investment Banking? Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 5C A R E E R L I B R A R Y For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance
  21. 21. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.6 Vault Career Guide to Investment Banking What is Investment Banking? The Game Generally, the breakdown of an investment bank includes the following areas: The functions of all of these areas will be discussed in much more detail later in the book. In this overview section, we will cover the nuts and bolts of the business, providing an overview of the stock and bond markets and how an I-bank operates within them. Corporate finance The bread and butter of a traditional investment bank, corporate finance generally performs two different functions: 1) Mergers and acquisitions advisory and 2) Underwriting. (1) On the mergers and acquisitions (M&A) advising side of corporate finance, bankers assist in negotiating and structuring mergers between companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth transaction. In the last few years, the M&A market has been white-hot, as companies have large cash balances with which they can complete strategic transactions. (2) The underwriting function within corporate finance involves the process of raising capital for a company. In the investment banking Corporate Finance (equity) Corporate Finance (debt) Mergers & Acquisitions (M&A) Equity Capital Markets Debt Capital Markets Equity Sales Fixed Income Sales Syndicate (equity) Syndicate (debt) Equity Trading Fixed Income Trading Equity Research Fixed Income Research
  22. 22. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 7C A R E E R L I B R A R Y Vault Career Guide to Investment Banking What is Investment Banking? world, capital can be raised by selling either equity (stocks) or debt (bonds or loans) (as well as some more exotic securities) to investors. Underwriting is unique, in that it involves the investment bank assuming a large amount of risk. Essentially, in the case of a bond offering, you can think of the process of underwriting as an investment bank writing a check to a company, then raising the funds in the markets from investors. This means that the investment bank assumes the risk of the transaction not selling in the market. Think of this as buying pizza for friends and relying on them to pay you back. If you’ve ever done this, you’ve “underwritten” a transaction. Although performing two functions, corporate finance is often divided into a number of industry-focused groups, called “coverage” groups. Coverage groups are usually aligned by a client’s industry and can potentially include aerospace & defense, automotive, consumer goods, diversified industrials, FIG (financial institutions and governments), financial sponsors, healthcare, natural resources (oil & gas, metals & mining, power), TMT (technology, media, telecom), real estate, and transportation. As these groups focus on industries and relationships, they are able to become very close to the clients and their needs. Therefore, it is not uncommon for M&A advisory work to either be done within these groups, or as a completely separate group, also broken into industry coverage teams. As those in corporate finance are privy to private company information, such as forward-looking financials, they are considered on the “private side” of the so-called Chinese wall and are unable to sell or trade such privileged information. Capital markets The role of capital markets is managing the interaction of the bankers in corporate finance with those in sales & trading (as well as research). Generally placed under the “corporate finance” umbrella, these jobs blend a bit of both corporate finance and sales & trading. Capital markets professionals are responsible for understanding recent transactions in the financial markets and using this information to structure new transactions. They serve as invaluable market advisors for their firm’s deals and many times are the leads in executing deals originated from other areas in corporate finance. Capital markets professionals are also usually grouped into either equity capital markets or debt capital markets. As they are also privy to private information, such as forward-looking financials of companies, capital markets personnel are also on the “private side” of the Chinese wall.
  23. 23. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking What is Investment Banking? © 2007 Vault Inc.8 Sales Sales is another core component of any investment bank. Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson, or 3) the private client service representative. Retail brokers develop relationships with individual investors and sell stocks and stock advice to the average Joe. Institutional salespeople develop business relationships with large institutional investors. Institutional investors are those who manage large groups of assets, for example pension funds, mutual funds, hedge funds, or large corporations. Private Client Service (PCS) representatives are somewhere between retail brokers and institutional salespeople in the spectrum, providing brokerage and money management services for extremely wealthy individuals. Salespeople make money through commissions on trades made through their firms or, increasingly, as a percentage of their clients’ assets with the firm. As investment bankers structure transactions requiring the issuance of new securities, salespeople are responsible for selling these securities to investors. Therefore, although a transaction might appear profitable on paper, it ultimately relies on those buying the securities and the investment bank’s relationships with those buyers. Furthermore, as those securities trade in the market, the salespeople are responsible for representing their clients and executing a purchase or sale on their behalf. As they usually interact with the public financial markets and do not have private information, sales people are generally considered to be on the public side of the Chinese wall. Trading Traders provide a vital role for the investment bank. In general, traders facilitate the buying and selling of stocks, bonds, and other securities such as currencies, futures, and derivatives, either by carrying an inventory of securities for sale or by executing a given trade for a client. A trader plays two distinct roles for an investment bank: (1) Providing liquidity: Traders provide liquidity to the firm’s clients (that is, providing clients with the ability to buy or sell a security on demand). Traders do this by standing ready to buy the client’s securities at any time (or sell securities to the client) if the client needs to place a trade quickly. This is also called making a market, or acting as a market maker. Traders performing this function make money for the firm by selling securities at a slightly higher price than they pay for them. This price differential is known as the bid-ask spread. (The bid price at any
  24. 24. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking What is Investment Banking? Visit the Vault Finance Career Channel at www.vault.com/finance — with insider firm profiles, message boards, the Vault Finance Job Board and more. 9C A R E E R L I B R A R Y given time is the price at which an investor can sell a security to another, which is usually slightly lower than the ask price, which is the price at which investors can buy the same security from another investor.) (2) Proprietary trading: In addition to providing liquidity and executing traders for the firm’s customers, traders also may take their own trading positions on behalf of the firm, using the firm’s capital hoping to benefit from the rise or fall in the price of securities. This is called proprietary trading. Typically, the marketing-making function and the proprietary trading function is performed by the same trader for any given security. For example, Morgan Stanley’s Five Year Treasury Note trader will typically both make a market in the 5-Year Note as well as take trading positions in the 5-Year Note for Morgan Stanley’s own account. Furthermore, a number of investment banks have standalone proprietary trading operations, whereby they act like independent hedge funds, investing the firm’s capital in an effort to maximize returns. Of the major investment banks, JPMorgan has the largest hedge fund presence with over $34 billion in assets under management, followed closely by Goldman Sachs. This hedge-fund style investing is prevalent at most all investment banks, but has come under much scrutiny at Goldman Sachs, where the firm’s revenues and pre-tax income from 2006 were substantially concentrated in “principal investing.” According to the firm’s annual report, close to 70 percent of its revenues and pre-tax income were concentrated in this investing area. As traders make markets and take positions in securities, they are considered on the public side of the Chinese wall. Unlike corporate finance investment bankers, they are not allowed private information, due to SEC regulations. Research Research analysts follow stocks and bonds and make recommendations to outside investors on whether to buy, sell, or hold those securities. They also forecast companies’ future earnings. Stock analysts (known as equity analysts) typically focus on one industry and will cover up to 20 companies’ stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as a particular industry’s high yield bonds. Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Reputable research analysts can generate substantial corporate finance business for their firm as well as
  25. 25. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking What is Investment Banking? © 2007 Vault Inc.10 substantial trading activity, and thus are an integral part of any investment bank. Research areas are usually placed under the sales & trading umbrella, due to the nature of their work in the financial markets. They too are part of the public side of the Chinese wall, using only public information to construct financial models and make recommendations. In some cases, successful research analysts will be recruited to work for the proprietary trading operations of an investment bank or will even be recruited by top-tier hedge funds due to their depth of knowledge of certain securities and markets. Syndicate The hub of the investment banking wheel, the syndicate group provides a vital link between salespeople and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a knock-down drag- out affair between and among buyers of offerings and the investment banks managing the process. In a corporate or municipal debt deal, syndicate also determines the allocation of bonds and loans. As the function is the hub of the wheel, it often works very closely with the professionals in capital markets. Syndicate is also occasionally referred to as “primary sales,” where securities are placed into the hands of investors for the first time. Once allocated to an investor, any trading of these securities happens in the secondary markets, which are what most people think of when they think of the financial markets. However, to avoid confusion, the primary markets are usually just referred to as “syndicate.”
  26. 26. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 11C A R E E R L I B R A R Y Before describing how an investment bank operates, let’s back up and start by describing traditional commercial banking. Commercial and investment banking share many aspects, but also have many fundamental differences. After a quick overview of commercial banking, we will build up to a full discussion of what I-banking entails. Although the barriers between investment and commercial banks have essentially been removed by the passage of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, we will for now examine the traditional model of the commercial banking industry and compare it to investment banking. We will then investigate how the new legislation affects commercial and investment banking organizations. Also, we will distinguish between the “buy-side” and the “sell-side” of the securities industry. It’s important to note that a number of banks have both commercial and investment banking operations. The largest and most active of these include JPMorganChase, Citigroup, and Bank of America. All three have separate entities for each function: commercial banking and investment banking. The synergy gained from their presence in both areas has enabled them to grow at astounding rates. Commercial Banking vs. Investment Banking While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a typical investment bank and a typical commercial operate bank can be simplified: A commercial bank takes deposits for checking and savings accounts from consumers, while an investment bank does not. We’ll begin examining what this means by taking a look at what commercial banks do. Commercial Banking, Investment Banking and Asset Management CHAPTER 2
  27. 27. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.1212 Commercial banks A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations. The typical commercial banking process is fairly straightforward. You deposit money into your bank, and the bank loans that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks range in size from the local dry cleaner to the multinational conglomerate such as GE, IBM, and Exxon Mobil. The commercial bank generates a profit by paying depositors a lower interest rate than the bank charges on loans. Examples of commercial banks include Chase, Bank of America, Citibank, PNC, and Wachovia. Private contracts Importantly, loans from commercial banks to individuals are structured as private legally binding contracts between two parties—the bank and you (or the bank and a company). Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. Your individual credit history (or credit risk profile) determines the amount you can borrow and how much interest you are charged. Perhaps you need to borrow $200,000 to purchase a home, or maybe you need $30,000 to finance the purchase of a car. Maybe for the first loan, you and the bank will agree that you pay an interest rate of 7.5 percent; perhaps for the car loan, the interest rate will be 6 percent. The rates are determined through a negotiation between you and the bank. Let’s take another minute to understand how a bank makes its money. On most loans, commercial banks in the U.S. earn interest anywhere from five to 14 percent. Ask yourself how much your bank pays you on your deposits—the money that it uses to make loans. You probably earn a paltry one percent on a checking account, if anything, and maybe three to four percent on a savings account. Commercial banks thus make money by taking advantage of the large spread between their cost of funds (one percent, for example) and their return on funds loaned (ranging from five to 14 percent). Vault Career Guide to Investment Banking Commercial Banking, Investment Banking...
  28. 28. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 13C A R E E R L I B R A R Y Commercial banks also make a substantial portion of their revenues from lending to corporations of all sizes. As companies seek to expand operations, they might use a loan to purchase a fleet of cars, or land to build a new headquarters. These loans are structured just like those to individuals, with an interest rate based on the credit worthiness of the company. Even the largest and most stable of companies, General Electric, has loans from commercial banks. However, as loans to large corporations are usually much larger in size (GE’s credit lines are estimated to be over $25 billion), commercial banks tend to divide up the exposure and build a “syndicate” of lenders. Many large commercial loans are even traded by institutional investors in the syndicated loan market. Investment banks An investment bank operates quite differently from a commercial bank. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, from a market-making perspective, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. An investment bank also provides advisory services (M&A), which does not require it to deal in the securities of the underlying companies. Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it can raise funds via a loan from a commercial bank or it may also ask an investment bank to sell equity or debt (stocks or bonds) on its behalf in the public markets. Because commercial banks already have funds available from their depositors and an investment bank typically does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client. This is where the investment banks with commercial banking arms excel. Many of these firms have access to billions of dollars of their own capital that they are able to lend immediately to clients in the form of underwriting. Vault Career Guide to Investment Banking Commercial Banking, Investment Banking...
  29. 29. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.1414 Vault Career Guide to Investment Banking Commercial Banking, Investment Banking... Loans (Private Debt) vs. Bonds (Public Debt) — An Example Let’s look at an example to illustrate the difference between loans and bonds. Suppose Acme Cleaning Company needs capital, and estimates its need to be $50 million. Acme could obtain a commercial bank loan from Bank of New York for the entire $50 million, and pay interest on that loan just like you would pay on a $5,000 personal finance loan from Bank of New York. Alternately, it could sell bonds publicly using an investment bank such as Merrill Lynch. The $50 million bond issue raised by Merrill would be broken into many smaller bonds and then sold to the public. (For example, the issue could be broken into 50,000 bonds, each worth $1,000.) Once sold, the company receives its $50 million (less Merrill’s fees) and investors receive bonds worth a total of the same amount. Over time, the investors in the bond offering receive coupon payments (the interest), and ultimately the principal (the original $1,000) at the end of the life of the loan, when Acme Corp buys back the bonds (retires the bonds). Thus, we see that in a bond offering, while the money is still loaned to Acme, it is actually loaned by numerous investors, rather than from a single bank. Because the investment bank involved in the offering does not own the bonds but merely placed them with investors at the outset, it earns no interest—the bondholders earn this interest in the form of regular coupon payments. The investment bank makes money by charging the client (in this case, Acme) a small percentage of the transaction upon its completion, while not holding the bonds. Investment banks call this upfront fee the “underwriting discount.” In contrast, a commercial bank making a loan of $50MM actually receives the interest and simultaneously owns the debt, or a portion thereof. Traditionally, for loans less than $50MM, it is typical for a commercial bank to be the sole lender. However, as investors have become more savvy and commercial loans have grown in size, the two markets are now quite similar. For loans larger than $100MM, it is not uncommon for there to be multiple commercial banks organized by an “arranger.” In many cases, the loans are large enough and liquid enough to be traded much like bonds in the secondary markets by institutional investors. In fact, the loan and bond markets are so similar that the major distinction is that the loan market is still a private market, whereas the bond market is not (also, the loan instrument is typically a floating-
  30. 30. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 15C A R E E R L I B R A R Y The question of equity or debt Investment banks underwrite stock offerings just as they do bond or loan offerings. In the stock offering process, a company sells a portion of the equity (or ownership) of itself to the investing public. The very first time a company chooses to sell equity, this offering of equity is transacted through a process called an initial public offering of stock (commonly known as an IPO). Through the IPO process, stock in a company is created and sold to the public. After the deal, stock sold in the U.S. is traded on a stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. We will cover the equity offering process in greater detail in Chapter 6. The equity underwriting process is another major way in which investment banking differs from commercial banking. Commercial banks (even before Glass-Steagall repeal) were able to legally underwrite debt, and some of the largest commercial banks have developed substantial expertise in underwriting bond and loan deals. So, not only do these banks make loans utilizing their deposits, they also underwrite deals through a corporate finance department. When it comes to underwriting these debt offerings, commercial banks have long competed for this business directly with investment banks. However, as a practical matter, only the biggest tier of commercial banks are able to do so, because the size of most debt issues is large and Wall Street competition for such deals is quite fierce. Not surprisingly, many of these commercial and investment banking competitors have merged to take advantage of their vast synergies. Vault Career Guide to Investment Banking Commercial Banking, Investment Banking... rate instrument, whereas bonds are usually thought of as fixed rate instruments). Thus, commercial banks are receiving the loan’s underwriting or arrangement fee (the difference is discussed later in Chapter 4), while also receiving interest on whatever portion of the loan it owns. Later, we will cover the steps involved in underwriting a public bond deal and a private loan deal. Legally, most bonds must first be approved by the Securities and Exchange Commission (SEC). (The SEC is a government entity that regulates the sale of all public securities.) The investment bankers guide the company through the SEC approval process, and then market the offering utilizing a written prospectus, its sales force and a roadshow to find investors.
  31. 31. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.1616 Ultimately, when choosing to raise capital, a company might have the option of equity or debt. Debt, representing a repayment obligation, comes with its own set of restrictions, but is usually less expensive than offering equity. However, unlike debt, equity does not require the company to pay regular interest payments to investors, yet it does require the company to sell a portion of itself to the general public. For a variety of reasons, a company might choose to issue one versus the other. Glass-Steagall Reform Previously, we briefly discussed that much has recently changed in the investment banking industry, driven primarily by the breakdown of the Glass-Steagall Act. This section will cover why the Act was originally put into place, why it was criticized, and how recent legislation will continue to impact the securities industry. The history of Glass-Steagall The famous Glass-Steagall Act, enacted in 1934, erected barriers between commercial banking and the securities industry. A piece of Depression-Era legislation, Glass-Steagall was created in the aftermath of the stock market crash of 1929 and the subsequent collapse of many commercial banks. At the time, many blamed the securities activities of commercial banks for their instability. Dealings in securities, critics claimed, upset the soundness of the banking community, caused banks to fail, and crippled the economy. Therefore, separating securities businesses and commercial banking seemed the best solution to provide solidity to the U.S. banking and securities’ system. In later years, a different truth seemed evident. The framers of Glass- Steagall argued that a conflict of interest existed between commercial and investment banks. The conflict of interest argument ran something like this: 1) A bank that made a bad loan to a corporation might try to reduce its risk of the company defaulting by underwriting a public offering and selling stock in that company; 2) The proceeds from the IPO would be used to pay off the bad loan; and 3) Essentially, the bank would shift risk from its own balance sheet to new investors via the initial public offering. Academic research and common sense, however, has convinced many that this conflict of interest isn’t valid. A bank that consistently sells ill-fated stock would quickly lose its reputation and ability to sell IPOs to new investors. Vault Career Guide to Investment Banking Commercial Banking, Investment Banking...
  32. 32. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Glass-Steagall’s fall in the late 1990s In the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s restrictions, the investment and commercial banking industries witnessed an abundance of commercial banking firms making forays into the I-banking world. The feeding frenzy reached a height in the spring of 1998. In 1998, NationsBank bought Montgomery Securities, Société Génerale bought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust (which had bought Alex. Brown months before), and Citigroup was created in a merger of Travelers Insurance and Citibank. While some commercial banks have chosen to add I-banking capabilities through acquisitions, some have tried to build their own investment banking business. JPMorgan stands as the best example of a commercial bank that entered the I-banking world through internal growth, although it recently joined forces with Chase Manhattan and, more recently, BankOne to form JPMorganChase. Interestingly, JPMorgan actually used to be both a securities firm and a commercial bank until federal regulators forced the company to separate the divisions. The split resulted in JPMorgan, the commercial bank, and Morgan Stanley, the investment bank. Today, JPMorgan has slowly and steadily clawed its way back to the pinnacle of the securities business, and Morgan Stanley has merged with Dean Witter to create one of the larger I- banks on the Street. Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 17C A R E E R L I B R A R Y Vault Career Guide to Investment Banking Commercial Banking, Investment Banking...
  33. 33. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary What took so long? So why did it take so long to enact a repeal of Glass-Steagall? There were several logistical and political issues to address in undoing Glass-Steagall. For example, the FDIC and the Federal Reserve regulate commercial banks, while the SEC regulates securities firms. A debate emerged as to who would regulate the new “universal” financial services firms. The Fed eventually won with Fed Chairman Alan Greenspan defining his office’s role as that of an “umbrella supervisor.” A second stalling factor involved the Community Reinvestment Act of 1977—an act that requires commercial banks to re- invest a portion of their earnings back into their community. Senator Phil Gramm (R-TX), Chairman of the Senate Banking Committee, was a strong opponent of this legislation while then-President Clinton was in favor of keeping and even expanding CRA. The two sides agreed on a compromise in which CRA requirements were lessened for small banks. In November 1999, Clinton signed the Gramm-Leach Bliley Act, which repealed restrictions contained in Glass-Steagall that prevent banks from affiliating with securities firms. The new law allows banks, securities firms, and insurance companies to affiliate within a financial holding company (“FHC”) structure. Under the new system, insurance, banking, and securities activities are “functionally regulated.” The Buy-Side vs. the Sell-Side The traditional investment banking world is considered the “sell-side” of the securities industry. Why? Investment banks create stocks and bonds, and sell these securities to investors. Sell is the key word, as I-banks continually sell their firms’ capabilities to generate corporate finance business, and salespeople sell securities to generate commission revenue. Who are the buyers (“buy-side”) of public stocks and bonds? They are individual investors (you and me) and institutional investors, firms like Fidelity and Vanguard, and organizations like Harvard University. The universe of institutional investors is appropriately called the buy-side of the securities industry and includes asset managers, pension funds, insurance firms, and hedge funds. Growth in the institutional investor universe during the past ten years has been largely fueled by the growth in the hedge fund universe, representing over a trillion dollars of assets under management. As hedge funds seek to place capital to work in more sophisticated ways, Vault Career Guide to Investment Banking Commercial Banking, Investment Banking... © 2007 Vault Inc.18
  34. 34. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking Commercial Banking, Investment Banking... Visit the Vault Finance Career Channel at www.vault.com/finance — with insider firm profiles, message boards, the Vault Finance Job Board and more. 19C A R E E R L I B R A R Y the markets have evolved, with investment banks now offering more complex financial products than ever. Fidelity, T. Rowe Price, Janus and other mutual fund companies represent a large portion of the buy-side business. Insurance companies like Prudential and Northwestern Mutual also manage large blocks of assets and are another segment of the buy-side. Yet another class of buy-side firms manage pension fund assets—frequently, a company’s pension assets will be given to a specialty buy-side firm that can better manage the funds and hopefully generate higher returns than the company itself could have. There is substantial overlap among these money managers—some, such as Putnam and T. Rowe, manage both mutual funds for individuals as well as pension fund assets of large corporations. Hedge Funds: What Exactly Are They? Hedge funds are one sexy component of the buy-side. Since the mid-1990s, hedge funds’ popularity has grown tremendously. Hedge funds pool together money from large investors (usually wealthy individuals) with the goal of making outsized gains. Historically, hedge funds bought individual stocks, and shorted (or borrowed against) the S&P 500 or another market index, as a hedge against the stock. (The funds bet against the S&P in order to reduce their risk.) As long as the individual stocks outperformed the S&P, the fund made money. Nowadays, hedge funds have evolved into a myriad of high-risk money managers who essentially borrow money to invest in a multitude of stocks, bonds, loans, and derivative instruments (these funds with borrowed money are said to be “leveraged”). Essentially, a hedge fund uses its equity base to borrow substantially more capital, and therefore multiply its returns through this risky leveraging. Buying derivatives is a common way to quickly leverage a portfolio. Because hedge funds have relatively few (and wealthy) shareholders, they remain largely unregulated. There are literally thousands of hedge funds; some of the most notable names are Citadel, D. E. Shaw, Highland Capital, and SAC Capital. As high- stakes money managers, many operate under the 2/20 rule, whereby 2% of the firms’ capital under management is used to operate the fund and 20% of the gains are paid out to the fund’s managers. Often times, the heads of these firms are the best-paid individuals on Wall Street, many of them personally earning hundreds of millions of dollars in recent years (it is rumored that Steven A. Cohen of SAC earned over $1 billion in 2005).
  35. 35. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.20 Conversely, as the nature of the business is based on risk, quite often firms can collapse very quickly. Recently, the hedge fund industry has come under intense scrutiny from regulators after the implosion of the $9 billion fund of Amaranth Advisors. Many also recall the most famous hedge fund collapse as the meltdown of Long-Term Capital Management (LTCM) in 1998. Vault Career Guide to Investment Banking Commercial Banking, Investment Banking... For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance
  36. 36. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 21C A R E E R L I B R A R Y “The Dow Jones Industrial Average added 38.93 points to 10,424.41, bolstered by a 1.2 percent gain in component Intel,” The Wall Street Journal reported on November 11, 2004. The Journal also reported that Intel gains helped boost the NASDAQ Composite Index, but oil futures were on the decline again.” If you are new to the financial industry, you may be wondering exactly what all of these headlines mean and how to interpret them. The next two chapters are intended to provide a quick overview of the financial markets and what drives them, and introduce you to some market lingo as well. For reference, many definitions and explanations of many common types of securities can be found in the glossary at the end of this guide. Bears vs. Bulls Almost everyone loves a bull market, and an investor seemingly cannot go wrong when the market continues to reach new highs. At Goldman Sachs, a bull market is said to occur when stocks exhibit expanding multiples—we will give you a simpler definition. Essentially, a bull market occurs when stock prices (as measured by an index like the Dow Jones Industrial or the S&P 500) move up. A bear market occurs when stocks fall. Simple. More specifically, bear markets generally occur when the market has fallen by greater than 20 percent from its highs, and a correction occurs when the market has fallen by more than 10 percent but less than 20 percent. An easy way to remember this principle is that, when attacking, a bull strikes up and a bear strikes down. The most widely publicized, most widely traded, and most widely tracked stock index in the world is the Dow Jones Industrial Average. The Dow was created in 1896 as a yardstick to measure the performance of the U.S. stock market in general. Initially composed of only 12 stocks, the Dow began trading at a mere 41 points. Today the Dow is made up of 30 large companies in a variety of industries and is measured in the thousands of points. Although the Dow is widely watched and cited because it’s comprised of select, very large companies (known as “large caps”), the Dow cannot gauge fluctuations and movements in smaller companies (or “small caps”). The Equity Markets CHAPTER 3
  37. 37. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.2222 In November 1999, the Dow Jones updated its composite, adding and removing companies to better reflect the current economy. Union Carbide, Goodyear Tire & Rubber, Sears, Roebuck & Co., and Chevron were removed. Microsoft, Intel, SBC Communications, and Home Depot were added. In 2004, more changes were made, as AT&T, Eastman Kodak and International Paper were replaced with AIG, Pfizer, and Verizon. Due to the merger of AT&T and SBC in late 2005, AT&T was re-added to the DJIA and SBC was removed. The stocks in the following chart comprise the index as of the publication of this guide. Components of the Dow Jones Industrial Average (as of 03/07) The Dow and NASDAQ The Dow has historically performed remarkably well, particularly in the late 1990s. After a stumble in the late 1990s/early 2000s, it recovered to reach all-time highs in April 2007. In 1997, the Dow was hovering near 7000, before soaring above 11,000 points in 2000. However, after correcting to mid 7000s in 2003, the Dow began an upward surge to its newest highs, above 13,000. Propelling the Dow throughout the late 1990s was an upward was a combination of the success of U.S. businesses in capturing productivity/efficiency gains, the continuing economic expansion, rapidly growing market share in world markets, and the U.S.’s global dominance in the expanding technology sectors. After a general economic downturn in 2001-2002, in addition to the 2001 terrorist attacks, the Dow retreated back to these early 1990 levels. However, record low borrowing rates, abundant corporate cash balances, low default rates (i.e. bankruptcies by companies), Vault Career Guide to Investment Banking The Equity Markets American Express General Motors Microsoft A.I.G Hewlett-Packard Pfizer AT&T Home Depot Inc Procter & Gamble Boeing Honeywell International United Technologies Coca-Cola Co. Walt Disney Citigroup Intel Wal-Mart Caterpillar IBM Verizon Johnson & Johnson Source: Dow Jones & Co.
  38. 38. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary positive global economic data, and the rise of corporate profits have all contributed to the Dow’s most recent surge. The NASDAQ Composite garnered significant interest in the late 1990s years mainly because it was (and still is) driven largely by technology- related stocks. The NASDAQ stock market is an electronic market on which the stocks of many well-known technology companies (including Microsoft and Intel) trade. The acronym is short for the National Association of Securities Dealers Automated Quotations. Now, over 3,000 companies are listed on the stock exchange. In early 2000, the NASDAQ market became the first stock market to trade two billion shares in a single day. Interestingly, NASDAQ is owned by The Nasdaq Stock Market Inc, which trades on the NASDAQ exchange under the symbol NDAQ. In early 2000, both the Dow and the NASDAQ were at record highs, but critics were wary of the end of the bull market. April 2000 was that end; both indices started a slow slide that lasted over a year and coincided with a general economic malaise. The indices’ slow slide became a free-fall on September 17, 2001, the first day of trading after the terrorist attacks on the World Trade Center and the Pentagon. The Dow fell 7.13 percent, losing 684.81, the largest point drop ever. The NASDAQ was down 6.83 percent, or 115.83 points. The plunge is a good illustration of how outside events affect the stock markets; investors feared the economic impact of the attacks and the ensuing military response. It’s worth noting that the markets reacted the same way after events of similar historical significance, including the bombing of Pearl Harbor and the assassination of President John F. Kennedy. In 2003, for the first year since 1999, the Dow Jones Industrial Index finished on an uptick, gaining 25.3 percent and surpassing the 25.2 percent climb it made in 1999. The NASDAQ composite index also ended 2003 in solid fashion, increasing 50 percent during the year. Driving the gains in the market were low interest rates, a weaker dollar and low inventories. The only real downtick during the year, when stocks hit their lows, came in March during the outset of the war in Iraq. Since this uptick in 2003, both indices have been on a long bull-market streak, with the Dow reaching record highs and the NASDAQ reaching levels not seen since 2001 (although still very far from its 2000 levels). In 2004, 2005, and 2006, the Dow returned approximately 3.1%, -0.6%, and 16.3%, while the NASDAQ returned approximately 8.6%, 1.4%, and 9.5%. As mentioned earlier, fueling this streak has been investor confidence, low interest rates, and positive economic sentiment throughout all major Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 23C A R E E R L I B R A R Y Vault Career Guide to Investment Banking The Equity Markets
  39. 39. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.2424 financial markets worldwide. Many investors expect that after such a long bull run, both indices are due for a correction. However, with abundant investor cash balances, healthy corporate balance sheets, and positive economic indicators, the economy could have plenty of fuel left in its tank for an extended run. Other benchmarks Besides the Dow Jones and the NASDAQ Composite, investors follow many other important benchmarks. The NYSE Composite Index, which measures the performance of every stock traded on the New York Stock Exchange, represents an excellent broad market measure. The S&P 500 Index, composed of the 500 largest publicly traded companies in the U.S., also presents a widely followed broad market measure, but, like the Dow, is limited to large companies. The Russell 2000 compiles 2000 small-cap stocks, and measures stock performance in that segment of companies. Furthermore, with the rise in Exchange Traded Funds (ETFs), indices can be replicated and invested in, just like individual stocks. Note that Wall Street money managers tend to measure their performance against one of these market indices, not individual stocks. Large-cap and small-cap At a basic level, market capitalization or market cap represents the company’s value according to the market and is calculated by multiplying Vault Career Guide to Investment Banking The Equity Markets A Word of Caution about the Dow While the Dow may dominate news and conversation, investors should take care to know it has limitations as a market barometer. For one, the Dow can move be swiftly moved by changes in only one stock. Roughly speaking, for every dollar that any Dow component stock moves, the Dow Index will move by approximately four points. This is especially troubling, when considering the rise in oil prices over the past few years, that a stock such as Exxon (which has gone from roughly $30 per share in 2003 to nearly $80 in late 2006) has single-handedly fueled nearly 200 points of the Dow’s growth. Also, the Dow is only composed of immense companies, and will only reflect movements in large-cap stocks. The Dow tends to have more psychological significance to individual investors than to professional investors, who tend to follow broader market indices.
  40. 40. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 25C A R E E R L I B R A R Y the total number of shares by share price. (This is the equity value of the company.) Companies and their stocks tend to be categorized into three broad categories: large-cap, mid-cap, and small-cap. While there are no hard and fast rules, generally speaking, a company with a market cap greater than $5 billion will be classified as a large-cap stock. These companies tend to be established, mature companies, although with some IPOs rising rapidly, this is not necessarily the case. Sometimes huge companies with $100 billion and greater market caps, for example, GE (~$380 billion) and Microsoft (~$300 billion), are called mega-cap stocks. Small-cap stocks tend to be riskier, but are also often the faster growing companies. Roughly speaking, small-cap stocks include those companies with market caps less than $1 billion. And as one might expect, the stocks in between $1 billion and $5 billion are referred to as mid-cap stocks. What moves the stock market? Not surprisingly, the factors that most influence the broader stock market are economic in nature. Among equities, corporate profits and interest rates are king. Corporate profits: When Gross Domestic Product slows substantially, market investors fear a recession and a drop in corporate profits. And if economic conditions worsen and the market enters a recession, many companies will face reduced demand for their products, company earnings will be hurt, and hence equity (stock) prices will decline. Thus, when the GDP suffers, so does the stock market. Interest rates: When the Consumer Price Index heats up, investors fear inflation. Inflation fears trigger a different chain of events than fears of recession. Most importantly, inflation will cause interest rates to rise. Companies with debt will be forced to pay higher interest rates on existing debt, thereby reducing earnings (and earnings per share). Compounding the problem, because inflation fears cause interest rates to rise, higher rates will make investments other than stocks more attractive from the investor’s perspective. Why would an investor purchase a stock that may only earn 8 percent (and carries substantial risk), when lower risk CDs and government bonds offer similar yields with less risk? These inflation fears are known as capital allocations in the market (whether investors are putting money into stocks vs. bonds), which can substantially impact stock and bond prices. Investors typically re-allocate funds from stocks to low-risk bonds when the economy experiences a slowdown and vice-versa when the opposite occurs. Vault Career Guide to Investment Banking The Equity Markets
  41. 41. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.2626 What moves individual stocks? When it comes to individual stocks, it’s all about earnings, earnings, earnings. No other measure even compares to earnings per share (EPS) when it comes to an individual stock’s price. Every quarter, public companies must report EPS figures, and stockholders wait with bated breath, ready to compare the actual EPS figure with the EPS estimates set by Wall Street research analysts (which are set from their continued conversations with the company). For instance, if a company reports $1.00 EPS for a quarter, but the market had anticipated EPS of $1.20, the stock will almost certainly be dramatically hit in the market by a sell-off during the next trading day. Conversely, a company that beats its estimates will typically rally in the markets. Earnings per share are often adjusted for unforeseen events, such as one-time charges, which allow investors to evaluate whether or not the core business of a firm is growing or declining. It is important to note at this point, that in the frenzied Internet stock market of 1999 and early 2000, investors did not show the traditional focus on near- term earnings. It was acceptable for many small technology companies to operate at a loss for a year or more, because these companies, investors hoped, would achieve long term future earnings. As investors believed these long term substantial earnings would translate into high eventual EPS, they continued to purchase the stocks, driving up the stock prices. However, when the markets turned in the spring of 2000, investors began to expect even “new economy” companies to demonstrate more substantial near-term earnings capacity. For many companies, this did not happen. For anything other than comparison purposes, the market does not care about last year’s earnings or even last quarter’s earnings. What matters most to an investor is what will happen in the near future. Investors maintain a tough, “what have you done for me lately” attitude, and forgive slowly a company that consistently fails to meet analysts’ estimates (“misses its numbers”). Vault Career Guide to Investment Banking The Equity Markets
  42. 42. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 27C A R E E R L I B R A R Y Stock Valuation Measures and Ratios As far as stocks go, it is important to realize that absolute stock prices mean nothing. A $100 stock could be “cheaper” than a $10 stock. To clarify how this works, consider the following ratios and what they mean. Keep in mind that these are only a few of the major ratios, and that literally hundreds of financial and accounting ratios have been invented to compare dissimilar companies. Again, it is important to note that most of these ratios were not as applicable in the market’s evaluation of certain Internet and technology stocks in the late 1990s. P/E ratio You can’t go far into a discussion about the stock market without hearing about the all-important price to earnings ratio, or P/E ratio. By definition, a P/E ratio equals the stock price divided by the earnings per share. Investors use the P/E ratio to indicate how cheap or expensive a stock is. Consider the following example. Two similar firms each have $1.50 in EPS. Company A’s stock price is $15.00 per share, and Company B’s stock price is $30.00 per share. Clearly, Company A is cheaper than Company B with regard to the P/E ratio because both firms exhibit the same level of earnings, but A’s stock trades at a higher price. That is, Company A’s P/E ratio of 10 (15/1.5) is lower than Company B’s P/E ratio of 20 (30/1.5). Hence, Company A’s stock trades at a lower price. The terminology one hears in the market is, “Company A is trading at 10 times earnings, while Company B is trading at 20 times earnings.” Twenty times is a higher multiple. However, the true measure of cheapness vs. richness cannot be summed up by the P/E ratio. Some firms simply deserve higher P/E ratios than others, and some deserve lower P/Es. Importantly, the distinguishing factor is the anticipated growth in earnings per share. Vault Career Guide to Investment Banking The Equity Markets Company Stock Price Earnings Per Share P/E Ratio A $ 15.00 $1.50 10x B $ 30.00 $1.50 20x
  43. 43. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary PEG ratio Because companies grow at different rates, another comparison investors often make is between the P/E ratio and the stock’s expected growth rate in EPS. Returning to our previous example, let’s say Company A has an expected EPS growth rate of 10 percent, while Company B’s expected growth rate is 20 percent. We might propose that the market values Company A at 10 times earnings because it anticipates 10 percent annual growth in EPS over the next five years. Company B is growing faster—at a 20 percent rate—and therefore justifies the 20 times earnings stock price. To determine true cheapness, market analysts have developed a ratio that compares the P/E to the growth rate—the PEG ratio. In this example, one could argue that both companies are priced similarly (both have PEG ratios of 1). Sophisticated market investors therefore utilize this PEG ratio rather than just the P/E ratio. Roughly speaking, the average company has a PEG ratio of 1:1 or 1 (i.e., the P/E ratio matches the anticipated growth rate). By convention, “expensive” firms have a PEG ratio greater than one, and “cheap” stocks have a PEG ratio less than one. Cash flow multiples For companies with no earnings (or losses) and therefore no EPS (or negative EPS), one cannot calculate the P/E ratio—it is a meaningless number. An alternative is to compute the firm’s cash flow and compare that to the market value of the firm. The following example illustrates how a typical cash flow multiple like Enterprise Value/EBITDA ratio is calculated. EBITDA: A proxy for cash flow, EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To calculate EBITDA, work your way up the Income Statement, adding back the appropriate items to net income. Depreciation and amortization are added back, as they are not actual cash-based costs. Taxes are added back, because © 2007 Vault Inc.2828 Vault Career Guide to Investment Banking The Equity Markets Company Stock Price Earnings Per Share P/E Ratio A $ 15.00 $1.50 10x B $ 30.00 $1.50 20x Estimated Growth Rate in EPS 10x 20x
  44. 44. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary taxes are paid only if a company is profitable after it has paid for everything else. Interest is added back too, as it is paid on existing debt, for which the cash flow could potentially be used to do other things. (Note: For a more detailed explanation of this and other financial calculations, see the Vault Guide to Finance Interviews.) Adding together depreciation and amortization to operating earnings, a common subtotal on the income statement, can serve as a shortcut to calculating EBITDA. Enterprise value (EV) = market value of equity + net debt. To compute market value of equity, simply multiply the current stock price times the number of shares outstanding. Net debt is simply the firm’s total debt (as found on the balance sheet) minus cash. Enterprise value to revenue multiple (EV/revenue) If you follow startup companies or young technology or healthcare related companies, you have probably heard the multiple of revenue lingo. Sometimes it is called the price-sales ratio (though this technically is not correct). Why use this ratio? For one, many firms not only have negative earnings, but also negative cash flow. That means any cash flow or P/E multiple must be thrown out the window, leaving revenue as the last positive income statement number left to compare to the firm’s enterprise value. Specifically one calculates this ratio by dividing EV by the last 12 months revenue figure. Return on equity (ROE) ROE = Net income divided by total shareholder’s equity. ROE is an important measure, especially for financial services companies, which evaluates the return on income that a firm earned in any given year. Return on equity is expressed as a percentage. Many firms’ financial goal is to achieve a certain level of ROE per year, say 20 percent or more. Vault Career Guide to Investment Banking The Equity Markets Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 29C A R E E R L I B R A R Y
  45. 45. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking The Equity Markets © 2007 Vault Inc.30 Value Stocks, Growth Stocks and Momentum Investors It is important to know that investors typically classify stocks into one of two categories – growth and value stocks. Momentum investors buy a subset of the stocks in the growth category. Value stocks are those that often have been battered by investors. Typically, a stock that trades at low P/E ratios after having once traded at high P/E’s, or a stock with declining sales or earnings fits into the value category. Investors choose value stocks with the hope that their businesses will turn around and profits will return. Or, investors perhaps realize that a stock is trading close to or even below its “break-up value” (net proceeds upon liquidation of the company), and hence have little downside. Growth stocks are just the opposite. High P/E’s, high growth rates, and often hot stocks fit the growth category. Technology stocks, with Basic Equity Definitions Common stock: Also called common equity, common stock represents an ownership interest in a company. The vast majority of stock traded in the markets today is common. Common stock enables investors to vote on company matters. Convertible preferred stock: This is a relatively uncommon type of equity issued by a company, often when it cannot successfully sell either straight common stock or straight debt. Convertible preferred stock usually pays dividends in a manner similar to the way a bond pays coupon payments. However, preferred stock ultimately converts to common stock after a period of time. Preferred stock can be viewed as a mix of debt and equity, and is most often used as a way for a risky company to obtain capital when neither debt nor equity works. In terms of its relative priority on the claim of the assets of a company in the event of a bankruptcy, preferred stock is higher on the food chain than common stock. Non-convertible preferred stock: Sometimes companies (usually those with steady and predictable earnings) issue non-convertible preferred stock that pays steady dividends. This stock remains outstanding in perpetuity and trades similar to bonds. Utilities represent the best example of non-convertible preferred stock issuers.
  46. 46. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Vault Career Guide to Investment Banking The Equity Markets Visit the Vault Finance Career Channel at www.vault.com/finance — with insider firm profiles, message boards, the Vault Finance Job Board and more. 31C A R E E R L I B R A R Y sometimes astoundingly high P/E’s, may be classified as growth stocks, based on their high growth potential. Keep in mind that a P/E ratio often serves as a proxy for a firm’s average expected growth rate, because as discussed, investors will generally pay a high P/E for a faster growing company. Momentum investors buy growth stocks that have exhibited strong upward price appreciation. Usually trading at or near their “52-week highs” (the highest trading price during the previous two weeks), momentum investors cause these stocks to trade up and down with extreme volatility. Momentum investors, who typically don’t care much about the firm’s business or valuation ratios, will dump their stocks the moment they show price weakness. Thus, a stock run-up by momentum investors can potentially crash dramatically as investors bail out at the first sign of trouble. For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance For more information on sales & trading careers, go to the Vault Finance Career Channel • Vault Career Guide to Sales & Trading • Vault Career Guide to Hedge Funds • Detailed 40-page employer profiles on top employers like Goldman Sachs, Merrill Lynch, CSFB, UBS, JPMorgan Chase, Morgan Stanley and more www.vault.com/finance
  47. 47. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary How many consulting job boards have you visited lately? (Thought so.) Vault Consulting Job Board The most comprehensive and convenient job board for consulting professionals. Target your search by area of consulting, function, and experience level, and find the job openings that you want. No surfing required. VaultMatch Resume Database Vault takes match-making to the next level: post your resume and customize your search by area of consulting, experience and more. We’ll match job listings with your interests and criteria and e-mail them directly to your inbox. Use the Internet’s most targeted job search tools for consulting professionals.
  48. 48. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 33C A R E E R L I B R A R Y An Introduction to Debt Debt is everywhere. From credit cards to small business loans to multi- billion dollar bond issuances, debt is an integral part of the financial markets. Most everyone in the world has access to some form of debt. Although it normally has a negative connotation, debt is also the most common way for a company to raise capital. Most companies are simply too small (or do not want) to have public equity and be traded in the stock markets. Therefore, they opt for loans, bonds, or another form of debt to fill their day-to-day funding needs. For the average person, the debt markets are not as visible, nor as easy to understand as the equity market. In fact, despite this low profile, the debt markets are substantially larger than the equity markets. Even the bond market, which is just a subset of the overall debt market, is larger than the equity market. Historically, the debt markets were synonymous with “fixed income,” or products that had a fixed return, year over year (i.e. a bond’s coupon payments). However, in the past decade, as the syndicated loan market has grown and evolved, the debt markets have become both fixed and floating income markets. Now, many refer to the overall debt markets as the “credit markets,” which refers to an even larger umbrella that not only includes loans and bonds, as well as other related fixed income securities (ABS, MBS, etc.), but also the corresponding debt-related derivative instruments (CLOs, CDOs, Credit Default Swaps and Structured Credit). However, be aware that both the loan and bond markets (including securitizations) comprise the vast majority of the debt markets. What is the Bond Market? Until the late 1970s and early 80s, bonds were considered not very attractive investments, bought by retired grandparents, retirement funds, and insurance companies. They traded infrequently, and provided safe, steady returns. The term “clipping coupons” actually refers to retirees using the coupon payments from their bonds as income. The Debt Markets CHAPTER 4
  49. 49. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.3434 Beginning in the early 1980s, however, Wharton graduate and former Wall Street golden boy Michael Milken essentially created the “junk bond” financial market, while amassing a large fortune at the same time. This market would go on to create a number of other financial markets, and today still brings nearly $100 billion of annual new issuance of bonds to investors. With the development of mortgage-backed securities, Salomon Brothers also contributed to the bond market evolution, transforming bonds into something exciting and extremely profitable for investment banks. To begin our discussion of the fixed income portion of the debt market, we’ll identify the main types of securities that comprise it. We’ll discuss some of these more in-depth throughout the chapter. • U.S. Government Treasury securities • Agency bonds • High grade corporate bonds • High yield (junk) bonds • Municipal bonds • Mortgage-backed bonds • Asset-backed securities • Emerging market bonds • CDOs/CLOs Bond Market Indicators The yield curve Bond “yields” are the current rate of return to an investor who buys the bond. (Yield is measured in “basis points”; each basis point = 1/100 of one percent.) A primary measure of importance to fixed income investors is the yield curve. The yield curve (also called the “term structure of interest rates”) depicts graphically the yields on different maturity U.S. government securities. To construct a simple yield curve, investors typically look at the yield on a 90-day U.S. T-bill and then the yield on the 30-year U.S. government bond (called the Long Bond). Typically, the yields of shorter- term government T-bill are lower than Long Bond’s yield, indicating what is called an “upward sloping yield curve.” This is fairly intuitive, because as an investor, you would expect more return for your money if it were locked up in a longer-term investment. Sometimes, short-term interest rates are higher than long-term rates, creating what is known as an “inverse yield curve.” Vault Career Guide to Investment Banking Fixed Income Markets
  50. 50. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 35C A R E E R L I B R A R Y Bond indices As with the stock market, the bond market has some widely watched indexes of its own. One prominent example is the Lehman Government Corporate Bond Index (“LGC”). The LGC index measures the returns on mostly government securities, but also blends in a portion of corporate bonds. The index is adjusted periodically to reflect the percentage of assets in government and in corporate bonds in the market. Mortgage bonds are excluded entirely from the LGC index. U.S. government bonds Particularly important in the universe of fixed income products are U.S. government bonds. These bonds are the most reliable in the world, as the U.S. government is unlikely to default on its loans because it can essentially print money to meet its debt obligations. However, if it ever did default, the world financial markets would essentially be in shambles. Because they are virtually risk-free, U.S. government bonds, also called Treasuries, offer relatively low yields (a low rate of interest), and are the standards by which other bond yields are measured. If a financial ratio refers to the “risk-free rate of return”, it is usually referring to a specific U.S. Government Treasury security. Spreads In the bond world, investors track “spreads” as carefully as any single index of bond prices or any single bond. The spread is essentially the difference between a specific bond’s yield (the amount of interest, measured in percent, paid to bondholders), and the yield on a U.S. Treasury bond of the same time to maturity. For instance, an investor investigating the 20-year Acme Corp. bond would compare it to a U.S. Treasury bond that has 20 years remaining until maturity. Because U.S. Treasury bonds are considered to have zero risk of default, a corporation’s bond will always trade at a yield that is over the yield on a comparable Treasury bond. For Vault Career Guide to Investment Banking Fixed Income Markets
  51. 51. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.3636 example, if the Acme Corp. 10-year bond traded at a yield of 8.4 percent and a 10-year Treasury note was trading at 8 percent, a trader would say that the Acme bond was trading at “40 over” (here, the “40” refers to 40 basis points). Bond ratings for corporate and municipal bonds A bond’s risk level, or the risk that the bond issuer will default on payments to bondholders, is measured by bond rating agencies. Several companies rate credit, but Standard & Poor’s and Moody’s are the two largest. The riskier a bond, the larger the spread: low-risk bonds trade at a small spread to Treasuries, while below-investment grade bonds trade at tremendous spreads to Treasuries. Investors refer to company specific risk as credit risk. Triple A ratings represents the highest possible corporate bond designation, and are reserved for the best-managed, largest blue-chip companies. Triple A bonds trade at a yield close to the yield on a risk-free government Treasury. Junk bonds, or bonds with a rating of BB or below on the S&P scale, currently trade at yields ranging from 15 percent, depending on the precise rating and government bond interest rates at the time. Companies continue to be monitored by the rating agencies as long as their bonds trade in the markets. If a company is put on “credit watch,” it is possible that the rating agencies are considering raising or lowering the rating on the company. Often an agency will put a company’s bonds on credit watch “with positive or negative implications,” giving investors a preview of which way any future change will go. When a bond is actually downgraded by Moody’s or S&P, the bond’s price drops dramatically (and therefore its yield increases). The following table summarizes rating symbols of the two major rating agencies and provides a brief definition of each. It is important to note that at each major rating grade of S&P, there are + and -’s given to individual ratings. Thus, a bond could have a BB+, BB, or BB- rating. As with Moody’s, this distinction is made with a 1,2, or 3 scale, such that a bond could have a Ba1, Ba2, or Ba3 rating. The precise cutoff of investment grade bonds would be anything with a BB+ or lower rating from S&P or a Ba1 or lower rating from Moody’s. If a bond has obtained an investment grade rating from one agency and a high-yield rating from another, it is referred to as a “crossover credit” and usually falls into the world of high- yield bonds. Vault Career Guide to Investment Banking Fixed Income Markets
  52. 52. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary Visit the Vault Finance Career Channel at www.vault.com/finance – with insider firm profiles, message boards, the Vault Finance Job Board and more. 37C A R E E R L I B R A R Y Factors affecting the bond market What factors affect the bond market? In short, interest rates. The general level of interest rates, as measured by many different barometers (see inset) moves bond prices up and down, in dramatic inverse fashion. In other words, if interest rates rise, the bond markets suffer. Think of it this way. Say you own a bond that is paying you a fixed rate of 8 percent today, and that this rate represents a 1.5 percent spread over Treasuries. An increase in rates of 1 percent means that this same bond purchased now (as opposed to when you purchased the bond) will now yield 9 percent. And as the yield goes up, the price declines. So, your bond loses value and you are only earning 8 percent when the rest of the market is earning 9 percent. You could have waited, purchased the bond after the rate increase, and earned a greater yield. The opposite occurs when rates go down. If you lock in a fixed rate of 8 percent and rates plunge by 1 percent, you now earn more than those who purchase the bond after the rate decrease. Therefore, as interest rates change the price or value of bonds will rise or fall so that all comparable bonds will trade at the same yield regardless of when or at what interest rate these bonds were issued. Vault Career Guide to Investment Banking Fixed Income Markets S&P Moody’sRating AAA AaaHighest quality AA AaHigh quality A AUpper medium quality BBB BaaMedium grade BB BaSomewhat speculative B BLow grade, speculative CCC CaaLow grade, default possible CC CaLow grade, partial recovery possible C CDefault expected Source: Moody’s Investor’s Service and Standard and Poor’s Bond Rating Codes
  53. 53. Customizedfor:KarenXu(heykx@hotmail.com)SEOOnlineCareerLibrary © 2007 Vault Inc.3838 Why do interest rates move? Interest rates react mostly to inflation expectations (expectations of a rise in prices). If it is believed that inflation will rise, then interest rates rise. Think of it this way. Say inflation is 5 percent a year. In order to make money on a loan, a bank would have to at least charge more than 5 percent—otherwise it would essentially be losing money on the loan. The same is true with bonds and other fixed income products. In the late 1970s, interest rates topped 20 percent, as inflation began to spiral out of control (and the market expected continued high inflation). Today, many believe that the Federal Reserve has successfully slayed inflation and has all but eliminated market concerns of this amount of future inflation, at least in the near term. This is certainly debatable, but clearly, the sound monetary policies and remarkable price stability in the U.S. have made it the envy of many other financial markets around the world. Vault Career Guide to Investment Banking Fixed Income Markets Which Interest Rate Are You Talking About? Investment banking professionals often discuss interest rates in general terms. But what are they really talking about? So many rates are tossed about that they may be difficult to track. To clarify, we will take a brief look at the key rates worth tracking. We have ranked them in typically ascending order: the discount rate usually is the lowest rate; the yield on junk bonds is usually the highest. The discount rate: The discount rate is the rate that the Federal Reserve charges on overnight loans to banks. Today, the discount rate can be directly changed by the Fed, but maintains a largely symbolic role. Federal funds rate: The rate domestic banks charge one another on overnight loans to meet Federal Reserve requirements. This rate is also directly controlled by the Fed and is a critical interest rate to financial markets. T-Bill yields: The yield or internal rate of return an investor would receive at any given moment on a 90- to 360-day Treasury bill. LIBOR (London Interbank Offered Rate): Derived from the rate banks in England charge one another on overnight loans or loans up to five years. Often used by banks to quote floating rate loan interest rates. Typically, the benchmark LIBOR used on loans is the three-month rate.

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